Hedge Funds

Dead, or just resting?
May 26th 2005 | LONDON, NEW YORK AND PARIS
From The Economist

Reports of the death of hedge funds have been greatly exaggerated

THE list of the fallen is getting longer. At Bailey Coates, a London firm, one hedge fund is believed to have lost more than 20% of its net asset value so far this year. The Strategic Allocation Program of John W. Henry, of Boca Raton, Florida, is expected to be down by 27% in the course of 2005. Quadriga, an Austrian hedge-fund group, has two funds which have lost more than a fifth of their value since last December.

These are just a few of the hedge funds whose recent losses are hardly the “absolute returns” for which their clients pay generous fees—typically 1-2% of assets, plus 20% of returns, often above an agreed minimum. Some lost money on credit-market positions involving the huge debt of General Motors and Ford, whose recent tumble to junk status pushed credit spreads sharply wider. Others came a cropper in convertible-bond arbitrage. Both strategies, reckon researchers at Morgan Stanley, an investment bank, have cost their adherents 10-15% so far this year. Quadriga, which invests mainly in futures, lost some of its wagers on commodity and Treasury-bond prices.

Hedge Fund Research, in Chicago, calculates that hedge funds lost 0.7% on average in the first four months of the year. That still beat the S&P 500, which shed 4%, but was far from brilliant. Other hedge-fund number-crunchers show different figures but a similarly depressing recent trend. Are the funds on the brink of disaster? No, but their glory days may well be behind them. In a sense, they are victims of their own success.

Hedge funds—loosely regulated pools of investment capital that are supposedly for rich and knowledgeable investors alone—have grown explosively, as chart 1 indicates. They preserved their investors' capital when stock markets plunged in 2000, beating the index by a wide margin for each of the next three years (see chart 2). Since then, with returns to cash minimal, stocks going nowhere and bonds looking overpriced, investors have flocked to hedge funds to improve sparse returns.

Pension funds and insurers dipped cautious toes into the hedge-fund water. So did the fairly rich (following the very rich). Fast-growing “funds of hedge funds”, which spread investment among a number of hedge funds, gave new investors an easy (if expensive) way in. Today, though no one really knows, it is thought that some 8,000 funds manage at least $1 trillion in assets.

As their industry has grown, hedge funds have changed. Many have pushed into less liquid and more esoteric markets (distressed debt and structured finance, for example), as well as into anything but exotic long-only equity investment. They have also begun to use more borrowed money to enhance returns. Today, 70% of hedge funds have the ability to use some amount of leverage, says Hedge Fund Research. Many firms have geared up with debt equal to twice capital and some up to five times capital—though even that is far less than the levels seen in the 1990s.

Another change is the new importance of funds of hedge funds. These now account for some 45% of hedge-fund assets, up from 18% in 2000, according to Morgan Stanley, and for 60% of inflows. Many fund-of-funds managers are traders at heart and lack the longer-term commitment of a pension fund or an individual investor. By imposing their own fees on top of hedge funds' hefty charges, funds of hedge funds may have helped to create impossible targets for investment returns. And many use borrowed money to improve returns. A number of well-established hedge funds say they refuse to take money from leveraged funds of funds, but some newer ones are not so picky.

Has the quality of fund management deteriorated? Many think so. “What now travels under the name of hedge fund is often just speculation,” says Tim Price, of Ansbacher, a private bank. The barriers to entry for funds of hedge funds, in particular, are minimal. As a result, “a lot of capital has gone to average or below-average money managers,” says Jacob Schmidt of Allenbridge, a hedge-fund research firm.

For all their drawbacks and recent troubles, hedge funds have their uses. They provide liquidity to the markets, and they help companies to raise money and financial institutions to lay off risks. Whether or not they are now set for the meltdown that some have prophesied depends mainly on four things.

Whither hedge funds?

The first is whether investors exit en masse. Fed up with returns less glorious than those they expected, many are growing restless. Inflows may have been slowing already in the second half of 2004; new money in the first quarter of 2005 was a healthy $25 billion or more. But Hedge Fund Research notes a reduction in money from funds of hedge funds, which normally drive asset growth.

Morgan Stanley's researchers believe that last quarter may prove to have been the peak. Private money is coming in at half the rate it did a year ago, especially from among the lower ranks of rich individuals. Institutional investors are proving stauncher but it remains to be seen whether they are rattled by calls for public bodies such as California's state pension scheme, CalPERS, to reveal their hedge-fund investments.

The second question is whether recent ructions in the credit markets provoke a wave of redemptions by investors, forcing funds to sell what they can rather than what they should. Many funds lock in investors for at least three months, and June could prove a moment of truth. Hedge funds trying to unwind unprofitable positions now are having mixed results. “Material” liquidation is taking place in the convertible arbitrage market, says Huw van Steenis of Morgan Stanley. Structured finance seems to be proving more resistant.

A third issue is what will happen as interest rates—in America, anyway—rise. At the moment, historically low rates have cosseted hedge funds and other investment groups with big borrowings. “If interest rates increase, leveraged industries might get into trouble,” says Olivier Khayat, head of debt capital markets at Société Générale, a French bank.

A fourth question is whether any liquidations, forced or otherwise, prove contagious, thus destabilizing other markets and players. No one speaks so far of having seen the sort of contagion across asset classes that took place when Long-Term Capital Management got into trouble in 1998. But there are certainly risks that more and worse is to come.

The prevalence of funds of funds is one danger. Because they are often leveraged themselves (almost half can use borrowed money), if a fund in which they invest gets into trouble its losses are magnified at the fund-of-fund level, forcing it to pull money out of other, perhaps better managed, hedge funds in compensation. This could create a domino effect.

Another risk lies in the importance of hedge funds to the banks that serve them. Though hedge funds' assets account for only a tiny portion of global capital under management, their trading amounts to a high percentage of investment banks' revenues in some areas of business, especially convertible bonds and distressed debt, for example. They are also the banks' counterparties in transactions such as credit-default swaps. So any big troubles among hedge funds are likely to be felt by investment banks and prime brokerages. Small wonder that many analysts are downgrading the sector.

It can be argued that the sharp shock of recent weeks is just what was needed to scare low-quality money out of the hedge-fund business. “This is a healthy shake-up of the industry,” says Charles Gradante of the Hennessee Group, a research firm specializing in hedge funds. If he is right, a stronger industry will emerge.